What is a subordinated loan?
A subordinated loan is a type of debt that receives a lower priority level in terms of its claim to a company’s assets when the company goes bankrupt. If a company defaults on its debts, the debts have an order of priority that determines when or if they will receive payment. Subordinated loans only get paid back after several other creditors.
When a company goes bankrupt or is forced to liquidate its assets, it still has to pay its creditors. Subordinated loans have the lowest seniority in the hierarchy of debt claims, which means that there may be a long wait for the creditor to be paid back. Once all of the unsubordinated debt holders receive payment, the subordinated debt issuers are next in line.
But sometimes they may never get paid back at all. In some cases, there is no cash left after paying the unsubordinated lenders. Below subordinated loans are common stock holders, and above subordinated loans are preferred stock holders and other senior debt types, tax liabilities, and the liquidator.
Since subordinated debt has a lower level of priority when it comes to the company’s repayment obligation, it is riskier than unsubordinated debt. In exchange for this extra level of risk, subordinated loan holders usually receive higher rates of interest than higher-priority lenders.
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Subordinated loan example
Juicemachine, a startup selling expensive juice, has $10 million in debt. When it discovers that it can no longer keep running, it declares bankruptcy and begins the process of paying off its creditors. The first to get paid are the holders of preferred stock, the most senior type of debt the company issued. After paying off the debt holders in the hierarchy, Juicemachine finally pays off its subordinated loans: bonds issued by banks.